This week’s article comes from friend and frequent blog contributor Michael Toma.
Michael Toma, CRM, is the author of The Risk of Trading: Mastering the Most Important Element of Financial Speculation, in which he details his data-driven risk-based approach to long-term success in trading. Mr. Toma received the Certified Risk Manager (CRM) designation for risk management excellence from the National Alliance in 2007. In addition to his corporate risk consulting business, he actively trades the US-based futures and options markets.
Negotiating at a car dealership can be a trying process. Lease or finance, I have a dollar number in mind with some flexibility if they include my heated seats. The dealer estimates up front what price they think will move inventory and knows what their average sale price needs to be in order to meet his goals. Based on prior sales, they will also know if they can be strict with bargaining or if they need to be more flexible given a new delivery of inventory on its way.
The markets work in the same fashion. Take a full day’s trading activity in any market and look at the entire days trading range. Somewhere in that range, there is a price where the most trades were conducted, or as in the car example, where most buyers and sellers were comfortable doing business.
Traders often look at a certain range of prices, rather than a specific price tick to determine such areas of value.
Market profile theory looks at the markets with this auction-like lens where prices are negotiated and agreed upon. Factors such as oversupply or too much demand will push price away from this ‘point of control’ and ultimately establish a new average price to conduct business. This supply (sellers) and demand (buyers) battle can be seen in the markets all the time.
Market profile specifically identifies the range, or “value area” where near 70% of all trading activity took place during a specific period of time.
Market profile is a critical tool in my trading in many ways:
So how can traders take advantage of market profile?
Price, first and foremost, is a luring advertising mechanism enticing participants to get in or get out of a trade. If we trade while at the point of control, we, in essence, are betting that price will move away from that popular price and want to establish a new area to conduct business.
When we buy or sell outside the value area, we are either betting that price will revert back to the value area where most of the prior transactions were conducted or perhaps look to establish a continuation of the current trend. Sounds easy, right?
By no means is MP a buy/sell indicator system. Markets are subject to many factors that allow the price to stick near value areas or trend outside of it. Economic news, trader panic, and even seasonality can play a big role in market movement in and out of value. And just because price establishes a new point of control, it doesn’t mean the market participants will want to get too comfortable there for too long.
Consider taking a data-driven approach to the markets with the market profile. The value area is my sandbox for scalping strategies assuming that price will chop around the POC and act like a magnet within the borders of the sandbox.
Once price is outside, I focus on trend trading methods and look to use trailing stops. In summary, I have two places to play and different approaches for each. Do I have scalping trades that result in breakouts and vice versa? You bet, and the value areas can act as great stop loss points when the markets want to play games. Rule-based risk management at its finest!
Continuously ask yourself these two questions:
‘What is the market trying to do and how good of a job is it doing?’
In other words, is price happily rotating in the sandbox or is it successfully exploring to find values higher or lower than in prior sessions. Often, it is equally as important to find out what is not happening and market profile is a great tool for this.
Remember, markets trend only 20-30% of the time and many trend-following systems require sustained price movement to be successful. Ever notice after a big move, price will just stall and digest it? The overused ‘trend is your friend’ often can be limited by us market profilers.
Many traders play the gap, which is the difference between the closing price and the next day’s opening price. I like trading the prior day S&P close and the S&P futures overnight close for my gaps. Overall the strategy has a historical positive result without intraday stops, however, playing the gap when the opening price is within the prior day’s value area provides an even greater edge. Why wouldn’t it since in this scenario price is opening in its comfortable sandbox and often just probes its way to gap closure.
When the prior day’s close is at or near the point of control, look for a double magnet opportunity of confluence to go back and test that area during the session. Price is being ‘accepted’ thereby both buyers and sellers with lots of trade being facilitated.
Bollinger bands will ‘squeeze’, Heiken Ashi bars and Average True Range indicators will mimic chop while the overall tape will slow down in the process until new a new value area is found.
There’s lots of other high probability plays to consider using market profile. Want more? Come join us at the next Montreal Traders Group meeting. See you there!